Analysing the Telstra buy-back: Part 1 (Super funds)

Telstra has finalised the details of its off-market buy-back. Here, we run the ruler over it from a super fund perspective.

Key Points

  • Benefit of franking credits can be shared amongst different classes of shareholder
  • Telstra buy-back attractive to pension mode super funds who wish to sell
  • For accumulation funds, depends on the final price and the value they place on capital losses

On 14 August we purchased 1,200 shares in Telstra (ASX Code: TLS) for each of our model portfolios (see franked dividend (with franking credits attached). This is attractive to shareholders like super funds (which have low rates of tax and can have franking credits refunded) but less so to individuals on higher tax rates (who are taxed more heavily on dividends than capital gains) and non-residents that can’t claim franking credits.

But there’s the inevitable catch: the value of the credits is shared with non-participating shareholders through the off-market buy-back occurring at a discount to the prevailing market price.

Telstra’s buy-back will be at a discount of 6-14% (to be determined through a tender process), although we’d expect it to be at the higher end of this range. Table 1 shows the buy-back prices – and the various components – at a range of discounts and share price levels.

Buy-back discount Buy-back price/components Share Price at time of buy-back
Table 1: Matrix of buy-back prices
     5.40  5.70  6.00
         
6% Buy-back price  5.08  5.36  5.64
  Capital component  2.33  2.33  2.33
  Franked dividend  2.75  3.03  3.31
  Franking credit  1.18  1.30  1.42
  Total  6.25  6.66  7.06
         
8% Buy-back price  4.97  5.24  5.52
  Capital component  2.33  2.33  2.33
  Franked dividend  2.64  2.91  3.19
  Franking credit  1.13  1.25  1.37
  Total  6.10  6.49  6.89
         
10% Buy-back price  4.86  5.13  5.40
  Capital component  2.33  2.33  2.33
  Franked dividend  2.53  2.80  3.07
  Franking credit  1.08  1.20  1.32
  Total  5.94  6.33  6.72
         
12% Buy-back price  4.75  5.02  5.28
  Capital component  2.33  2.33  2.33
  Franked dividend  2.42  2.69  2.95
  Franking credit  1.04  1.15  1.26
  Total  5.79  6.17  6.54
         
14% Buy-back price  4.64  4.90  5.16
  Capital component  2.33  2.33  2.33
  Franked dividend  2.31  2.57  2.83
  Franking credit  0.99  1.10  1.21
  Total  5.64  6.00  6.37

Participating shareholders need to weigh up the cash cost of the discount and the higher tax bill (if any) on the franked dividend component, against the franking credits and (if relevant) the value of the extra capital losses the off-market buy-back generates.

Let’s run through some calculations, starting with the simplest example: the pension mode (0% tax) super fund.

Pension mode super fund

The analysis for pension mode super funds is fairly straight forward. They don’t have to pay any additional tax on the franked dividend, nor assess the value of capital losses, since they don’t pay tax on anything.

The buy-back discount is typically set below the value of the franking credits, which means a pension mode super fund is almost always better off participating in an off-market buy-back rather than selling on-market.

Table 2 shows the analysis, based on the maximum discount of 14%, and it’s a clear win to the buy-back. If the discount gets set at a lower level, the financial benefit of the buy-back (compared to selling on-market) is even bigger.

Analysis of buy-back  
Table 2: Analysis of buy-back for pension mode super fund
Total cash proceeds  
Buy-back price  4.90
Consists of:  
Capital component  2.33
Franked dividend component  2.57
Franking credit (refundable)  1.10
Total cash proceeds from buy-back  6.00
Analysis of sale on-market  
Total cash proceeds from selling on-market (2) (3)  5.70
 
Assumptions:
(1) Telstra share price is $5.70 and buy-back discount is 14% (maximum)
(2) Calculations do not include potential future value of capital losses if new taxes are introduced
(3) Brokerage not included

Accumulation mode super fund

Super funds in accumulation mode are more complicated. Off-market buy-backs can be better for accumulation funds than selling on-market, but it depends on a few key factors.

1.     Buy-back discount. A discount at the lower end of the range (6%) makes the buy-back generally attractive to accumulation funds, but with higher discounts other factors (below) come into play.

2.     Cost-base of shares. Accumulation funds will have a cost base (for capital gains tax (CGT) purposes). Telstra shares bought in 2010 and 2011 would have a cost base around $3, but longer term shareholders might have a cost base more than double that.

3.     Capital gains on other investments. A fund with a sufficiently high cost base will generate a capital loss by participating in the off-market buy-back. This is useful if the fund has other capital gains (which the loss can be used to reduce), but less useful if it has to be carried forward for possible future use and useless if the fund doesn’t have capital gains (for example, it switches to pension mode before realising profits).

4.     Existence of non-discounted capital gains. The capital loss referred to above is more valuable if it can be offset against non-discounted capital gains (on assets held less than 12 months) since the fund would otherwise have to pay tax on the entire gain (not two-thirds of it). Depending on the buy-back discount, this factor alone can tip the scales in favour of participating in the buy-back (more below).

Telstra has provided a downloadable calculator (you can access it here) that takes these factors into account. Note the ‘Deemed Adjustment to Capital Component’, explained on pages 18 and 19 of the Offer Booklet. The calculation appears to have been devised by a team of investment bankers but, behind the complexity, the basic idea is that an amount approximating to the buy-back discount is added to the Capital Component to work out your sales proceeds for CGT purposes.

The precise Deemed Adjustment won’t be known until the buy-back closes, so Telstra has opted for the simple approach of making it the same as the buy-back discount. We’ll do likewise in our calculations, but be aware that the final capital gain or loss under the buy-back might differ by a few cents.

Let’s now look at the Telstra buy-back, assuming a buy-back discount of 10%.

At this level, the Telstra deal should be attractive to many accumulation funds. Table 3 shows the numbers for funds with a range of cost bases (low to high). In this case, it’s clearly attractive to the funds with the low and medium cost bases and to those with high cost bases that can use the capital losses the buy-back generates. Even if they can’t, they’re still better off under the buy-back (but by a smaller amount).

  Taxpayer's cost base in shares
Table 3: Analysis of buy-back for accumulation (15%) fund (10% discount)
  Low ($3) Med ($4) High ($6)
Analysis of buy-back      
Income tax calculations      
Buy-back price  5.13  5.13  5.13
Less: capital component  2.33  2.33  2.33
Franked dividend component  2.80  2.80  2.80
Add: franking credit  1.20  1.20  1.20
Assessable (taxable) income  4.00  4.00  4.00
Gross tax payable (assess income x tax rate) -0.60 -0.60 -0.60
Add: franking credit offset/refund  1.20  1.20  1.20
Net tax refundable/(payable)  0.60  0.60  0.60
Capital Gains Tax calculations      
Capital Component  2.33  2.33  2.33
Add: Deemed adjustment to Capital Component  0.57  0.57  0.57
Total Capital Proceeds  2.90  2.90  2.90
Less: Assumed cost base -3.00 -4.00 -6.00
Net capital gain/(loss) -0.10 -1.10 -3.10
Net tax payable on capital gain (capital gain x tax rate) (2)  -    -    -  
Total cash proceeds      
Buy-back price  5.13  5.13  5.13
Add/subtract: Net tax refundable/(payable)  0.60  0.60  0.60
Subtract: Net tax payable on capital gain (2)  -    -    -  
Total cash proceeds from buy-back  5.73  5.73  5.73
Value of capital loss (3)  0.01  0.11  0.31
       
Analysis of sale on-market      
Capital Gains Tax calculations      
Sales proceeds (4)  5.70  5.70  5.70
Less: Assumed cost base -3.00 -4.00 -6.00
Net capital gain/(loss)  2.70  1.70 -0.30
Net tax payable on capital gain (2) -0.27 -0.17  -  
Total cash proceeds      
Sales proceeds  5.70  5.70  5.70
Less: Net tax payable on capital gain (2) -0.27 -0.17  -  
Total cash proceeds from selling on-market  5.43  5.53  5.70
Value of capital loss (3)  -    -    0.03
 
Assumptions:
(1) Telstra share price is $5.70 and buy-back discount is 10%
(2) Capital gains discounted by 1/3 (for assets held greater than 12 mths)
(3) Capital loss can be offset against discounted capital gains
(4) Brokerage not included

At a 12% discount (Table 4) things get a little trickier. Funds with low and medium cost bases are still clearly better off, but the ‘high cost base’ fund is only better off if it can use capital losses to offset other capital gains (either now, or in the near future). If it can’t, participating in the buy-back would leave it worse off compared to selling on-market.

  Taxpayer's cost base in shares
Table 4: Analysis of buy-back for accumulation (15%) fund (12% discount)
  Low ($3) Med ($4) High ($6)
Analysis of buy-back      
Income tax calculations    
Buy-back price  5.02  5.02  5.02
Less: capital component  2.33  2.33  2.33
Franked dividend component  2.69  2.69  2.69
Add: franking credit  1.15  1.15  1.15
Assessable (taxable) income  3.84  3.84  3.84
Gross tax payable (assess income x tax rate) -0.58 -0.58 -0.58
Add: franking credit offset/refund  1.15  1.15  1.15
Net tax refundable/(payable)  0.57  0.57  0.57
Capital Gains Tax calculations    
Capital Component  2.33  2.33  2.33
Add: Deemed adjustment to Capital Component  0.68  0.68  0.68
Total Capital Proceeds  3.01  3.01  3.01
Less: Assumed cost base -3.00 -4.00 -6.00
Net capital gain/(loss)  0.01 -0.99 -2.99
Net tax payable on capital gain (capital gain x tax rate) (2)  -    -    -  
Total cash proceeds      
Buy-back price  5.02  5.02  5.02
Add/subtract: Net tax refundable/(payable)  0.57  0.57  0.57
Subtract: Net tax payable on capital gain (2)  -    -    -  
Total cash proceeds from buy-back  5.59  5.59  5.59
Value of capital loss (3) -  0.10  0.30
     
Analysis of sale on-market    
Capital Gains Tax calculations    
Sales proceeds (4)  5.70  5.70  5.70
Less: Assumed cost base -3.00 -4.00 -6.00
Net capital gain/(loss)  2.70  1.70 -0.30
Net tax payable on capital gain (2) -0.27 -0.17  -  
Total cash proceeds      
Sales proceeds  5.70  5.70  5.70
Less: Net tax payable on capital gain (2) -0.27 -0.17  -  
Total cash proceeds from selling on-market  5.43  5.53  5.70
Value of capital loss (3)  -    -    0.03
 
Assumptions:
(1) Telstra share price is $5.70 and buy-back discount is 12%
(2) Capital gains discounted by 1/3 (for assets held greater than 12 mths)
(3) Capital loss can be offset against discounted capital gains
(4) Brokerage not included

Finally, to the maximum 14% discount, which, for most funds, means the offer is probably not worth participating in (see Table 5). But remember that this calculation assumes you’re eligible for the capital gains discount on your Telstra shares.

  Taxpayer's cost base in shares
Table 5: Analysis of buy-back for accumulation (15%) fund (14% discount)
  Low ($3) Med ($4) High ($6)
Analysis of buy-back      
Income tax calculations      
Buy-back price  4.90  4.90  4.90
Less: capital component  2.33  2.33  2.33
Franked dividend component  2.57  2.57  2.57
Add: franking credit  1.10  1.10  1.10
Assessable (taxable) income  3.67  3.67  3.67
Gross tax payable (assess income x tax rate) -0.55 -0.55 -0.55
Add: franking credit offset/refund  1.10  1.10  1.10
Net tax refundable/(payable)  0.55  0.55  0.55
Capital Gains Tax calculations      
Capital Component  2.33  2.33  2.33
Add: Deemed adjustment to Capital Component  0.80  0.80  0.80
Total Capital Proceeds  3.13  3.13  3.13
Less: Assumed cost base -3.00 -4.00 -6.00
Net capital gain/(loss)  0.13 -0.87 -2.87
Net tax payable on capital gain (capital gain x tax rate) (2) -0.01  -    -  
Total cash proceeds      
Buy-back price  4.90  4.90  4.90
Add/subtract: Net tax refundable/(payable)  0.55  0.55  0.55
Subtract: Net tax payable on capital gain (2) -0.01  -    -  
Total cash proceeds from buy-back  5.44  5.45  5.45
Value of capital loss (3)  -    0.09  0.29
       
Analysis of sale on-market      
Capital Gains Tax calculations      
Sales proceeds (4)  5.70  5.70  5.70
Less: Assumed cost base -3.00 -4.00 -6.00
Net capital gain/(loss)  2.70  1.70 -0.30
Net tax payable on capital gain (2) -0.27 -0.17  -  
Total cash proceeds      
Sales proceeds  5.70  5.70  5.70
Less: Net tax payable on capital gain (2) -0.27 -0.17  -  
Total cash proceeds from selling on-market  5.43  5.53  5.70
Value of capital loss (3)  -    -    0.03
 
Assumptions:
(1) Telstra share price is $5.70 and buy-back discount is 14%
(2) Capital gains discounted by 1/3 (for assets held greater than 12 mths)
(3) Capital loss can be offset against discounted capital gains
(4) Brokerage not included

If you’re not (because you bought the shares in the last 12 months and intend to sell them before qualifying for the discount) then this might tip the scales back (slightly) in favour of the buy-back, since you’d have to pay more tax on a sale on-market. However, this exception probably only applies in a very small number of cases, since many funds which bought in the last 12 months will have a cost base over $5 and not have to pay much CGT on an on-market sale anyway.

The main exception to the rule – that a 14% discount isn’t a good deal for accumulation funds – is where the fund has capital gains on other investments, which aren’t discounted. This increases the value of the capital losses calculated in Table 5.

It’s only likely to be interesting to those funds with a high cost base in their Telstra shares, since those with a low cost base won’t generate much of a capital loss (see Table 6). But if you bought Telstra in the early 2000s this might help ease the pain of having seen your original capital shrink.

  Taxpayer's cost base in shares
Table 6: Accum fund with non-concessional capital gains (14% discount)
  Low ($3) Med ($4) High ($6)
Analysis of buy-back      
Income tax calculations      
Buy-back price  4.90  4.90  4.90
Less: capital component  2.33  2.33  2.33
Franked dividend component  2.57  2.57  2.57
Add: franking credit  1.10  1.10  1.10
Assessable (taxable) income  3.67  3.67  3.67
Gross tax payable (assess income x tax rate) -0.55 -0.55 -0.55
Add: franking credit offset/refund  1.10  1.10  1.10
Net tax refundable/(payable)  0.55  0.55  0.55
Capital Gains Tax calculations      
Capital Component  2.33  2.33  2.33
Add: Deemed adjustment to Capital Component  0.80  0.80  0.80
Total Capital Proceeds  3.13  3.13  3.13
Less: Assumed cost base -3.00 -4.00 -6.00
Net capital gain/(loss)  0.13 -0.87 -2.87
Net tax payable on capital gain (capital gain x tax rate) (2) -0.01  -    -  
Total cash proceeds      
Buy-back price  4.90  4.90  4.90
Add/subtract: Net tax refundable/(payable)  0.55  0.55  0.55
Subtract: Net tax payable on capital gain (2) -0.01  -    -  
Total cash proceeds from buy-back  5.44  5.45  5.45
Value of capital loss (3)  -    0.13  0.43
       
Analysis of sale on-market      
Capital Gains Tax calculations      
Sales proceeds (4)  5.70  5.70  5.70
Less: Assumed cost base -3.00 -4.00 -6.00
Net capital gain/(loss)  2.70  1.70 -0.30
Net tax payable on capital gain (2) -0.27 -0.17  -  
Total cash proceeds      
Sales proceeds  5.70  5.70  5.70
Less: Net tax payable on capital gain (2) -0.27 -0.17  -  
Total cash proceeds from selling on-market  5.43  5.53  5.70
Value of capital loss (3)  -    -    0.05
 
Assumptions:
(1) Telstra share price is $5.70 and buy-back discount is 14%
(2) Capital gain (on Telstra only) discounted by 1/3 (for assets held greater than 12 mths)
(3) Capital loss can be offset against non-discounted capital gains
(4) Brokerage not included

That should cover all the scenarios SMSF trustees and other super funds are likely to face. In Part 2 we’ll look at the buy-back from the perspective of individuals and companies.

If you’ve got questions please let us know through the Q&A function.

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